Insurance policies can mean tax-free cash for sick clients

In some situations, it’s possible for the owner of a life insurance policy who is terminally or chronically ill to get cash out of the policy without any tax cost while he is still alive.

The policy owner may be able to receive an accelerated death benefit directly from the insurance company itself. However, the insurer may impose restrictions on this option. For example, an accelerated benefit may be available only to an insured with a life expectancy of six months to one year.

Alternatively, the policy owner may sell or assign the life insurance policy to a third party (usually called a “viatical settlement provider”). The provider is responsible for future premium payments and will receive the proceeds of the policy when the insured dies.

Observation: An insured who otherwise qualifies as terminally or chronically ill may have to sell or assign his policy to a viatical settlement provider if restrictions in the policy limit the ability to get an accelerated benefit from the insurer.

Example 1: Your client meets the definition of a terminally ill person because she has a life expectancy of only 18 months (see below). She would like to get an accelerated payment on her life insurance policy. However, the policy provides that an accelerated payment will be available only if her life expectancy is a year or less. She may still be able to get the funds she needs by selling or assigning her policy to a viatical settlement provider.

Regardless of whether the cash is received from a viatical settlement provider or the insurance company, the payment will be less than the face value of the policy. Viatical settlements generally pay between 60 percent and 80 percent of face value. The discount taken will depend on the insured’s life expectancy, the annual premium and other factors.

Recommendation: If the beneficiaries of the policy have funds that they can advance to the policy owner to provide for the owner’s needs, they should consider doing so. They often would be better off doing so since the amount they receive on the insurance policy on the death of the insured, less the amount they advanced to the insured, would be more than what would be left from the amount that the insured receives after paying his expenses. This is because the amount that the insured receives from an advance from the insurance company or from a sale or assignment to a viatical settlement provider is usually heavily discounted from the face amount to provide a profit for the payor.

Requirements for accelerated payments from insurance company and viatical settlement payments to be tax-free. For the payments to be tax free, the insured must be terminally ill or chronically ill. If the insured is terminally ill, the entire amount received is excluded from gross income. There is no requirement that the payments be used for any specific purpose.

On the other hand, a payment received for any period under a policy on the life of an individual who is chronically ill is excluded from gross income only to the extent that the payment is used to pay the costs of qualified long-term care services for the period. The costs paid must not be reimbursable by insurance or otherwise.

A payment to a chronically ill individual doesn’t fail to qualify for the exclusion merely because it is being made on a per diem or other periodic basis without regard to the expenses incurred during the period to which the payment relates. However, the amount of periodic payments that may be excluded under these rules is subject to a “dollar cap” on excludable benefits. The per diem limitation for any period is the excess (if any) of the greater of:

● A specified dollar amount per day ($220 per day for calendar year 2003) or the equivalent amount when payments are made on another periodic basis; or,

● The costs incurred for qualified long-term care services provided for the insured for the period, over the aggregate payments received as reimbursements (through insurance or otherwise) for qualified long-term care services provided for the insured during the period.

Thus, if payments exceed the dollar limitation, the excess is excludible only to the extent of actual costs incurred for long-term care services. Amounts in excess of the dollar limitation, with respect to which no actual costs are incurred for long-term care services, are fully includible in income without regard to rules relating to return of basis under the annuity rules of Internal Revenue Code § 72.

Example 2: Your client was chronically ill for the 90-day period from Jan. 15, 2003, through and including April 14, 2003.

During that period, he incurred costs in the total amount of $35,000 for qualified long-term care services. He was reimbursed $18,000 for these costs from his health insurance. He also received $21,000 from a viatical settlement provider by selling a life insurance policy with a face value of $30,000.

He is able to exclude $19,800 of the $21,000 received on the sale of the policy from his gross income. This is the greater of $17,000 (the excess of $35,000 of costs over the $18,000 reimbursed) or $19,800 (90 days times $220 per diem allowance). The balance of $1,200 received on the sale ($21,000 less $19,800) is includible in your client’s gross income.If the person making the payments to the owner of the life insurance policy is the issuing insurance company, the availability of the exclusion depends solely upon whether the insured meets the definition of either a terminally or chronically ill person.

On the other hand, if a policy insuring a terminally or chronically ill individual is sold or assigned, the owner may exclude all or part of the amounts received on the sale or assignment only if the buyer/assignee qualifies as a viatical settlement provider (see below).

The exclusion from gross income doesn’t apply for any amount paid to any taxpayer other than the insured if the payee has an insurable interest in the insured’s life because the insured is a director, officer or employee of the payee. The exclusion also doesn’t apply if the insured is financially interested in any trade or business carried on by the payee.

When an insured is considered terminally ill. For an insured to be considered terminally ill, a physician must certify that the insured has an illness or physical condition that can reasonably be expected to result in death within 24 months of the date of certification. A physician means a doctor of medicine or osteopathy legally authorized to practice medicine and surgery by the state in which he performs that function or action, including osteopathic practitioners within the scope of their practice as defined by state law.

When an insured is considered chronically ill. To be considered chronically ill, a physician or other licensed health care practitioner (e.g., nurse, social worker, etc.) must certify the insured as:

● Being unable to perform without substantial assistance at least two activities of daily living such as eating, toileting, transferring, bathing, dressing, and continence for at least 90 days due to a loss of functional capacity; or,

● Having a similar level of disability as determined by the Internal Revenue Service in consultation with the Department of Health and Human Services; or,

● Requiring substantial supervision for protection due to severe cognitive impairment (memory loss, disorientation, etc.)The 90-day period referred to with respect to being unable to perform at least two activities is not a waiting period. An individual can be certified as chronically ill if the licensed health care practitioner certifies that the individual will be unable to perform at least two activities of daily living for at least 90 days.

The certification may occur at any time, and is intended to take into account the sum of continuous prior days when the individual was chronically ill and future days when the individual is expected to remain chronically ill.

In determining whether an individual requires substantial supervision due to severe cognitive impairment, taxpayers may rely on either or both of the following safe-harbor definitions:

● Comparable to (and includes) Alzheimer’s disease and similar forms of irreversible dementia, and that is:

● Measured by clinical evidence and standardized tests that reliably measure impairment in the individual’s short-term or long-term memory; orientation as to people, places or time; and deductive or abstract reasoning.

2. Substantial supervision means continual supervision (which may include verbal prompting, gestures or other demonstrations) by another person, which is necessary to protect the severely cognitively impaired individual from threats to his health or safety (such as may result from wandering). An individual who is physically able but has a cognitive impairment such as Alzheimer’s disease or another form of irreversible loss of mental capacity is treated similarly to an individual who is unable to perform (without substantial assistance) at least two activities of daily living.

● Are provided under a plan of care prescribed by a licensed health care practitioner.

Maintenance or personal care services are any care the primary purpose of which is providing needed assistance with any of the disabilities as a result of which the individual is chronically ill (including protection from threats to health and safety due to severe cognitive impairment).

Maintenance and personal care services include meal preparation, household cleaning, and other similar services that the chronically ill individual is unable to perform.

A licensed health care practitioner is a physician, registered professional nurse, licensed social worker, or other individual who meets requirements that may be prescribed by the Internal Revenue Service.

A licensed social worker includes any social worker who has been issued a license, certificate or similar authorization to act as a social worker by a state or a body authorized by a state to issue such authorizations.

Viatical settlement provider defined. A viatical settlement provider is any person regularly engaged in the trade or business of purchasing, or taking assignments of, life insurance contracts on the lives of terminally ill or chronically ill insureds if:

● The person is licensed for those purposes in the state in which the insured resides; or,● In the case of an insured who resides in a state not requiring the type of licensing described in above, the person meets certain specified requirements. The requirements depend on whether the insured is terminally ill or chronically ill.

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